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Changes to EU emissions trading – how about your hedging strategy?

The European Union (EU) Emissions Trading System (ETS), the largest of its kind worldwide, is undergoing widespread change. New rules for phase 4 of the scheme starting in 2021 and reform of EU emissions trading came into effect from January 2019. The reforms had a significant impact on prices long before their introduction: between summer 2017 and autumn 2018, the price of CO2 emission certificates soared fivefold – causing considerable financial burdens especially for companies with higher CO2 emissions. It’s therefore crucial that affected companies fully understand the reforms, and how best to address them.

The four key legislative changes in the EU ETS*:

The number of EU emissions allowances auctioned off or issued free will be cut by 2.2% each year from 2021 – a considerable increase on the previous 1.74% envisaged by the ETS. These reductions are in line with the overarching goal of reducing CO2 emissions by 556 million metric tonnes between 2021 and 2030.

Between 2019 and 2030, the set-aside rate provided by the Market Stability Reserve (MSR) will double from 12% to 24% of the previous year’s cumulative surplus.

From 2023, it will be possible to eliminate certificates from the MSR in order to cut the surplus of emissions rights.

Certificates will also be subject to elimination on a voluntary basis. For example, certificates could be removed when decommissioning a coal-fired power station.

"Companies will have to change their purchasing strategy"

Ingo Ramming, Head of Corporate & Investor Solutions at Commerzbank – who is also an acting member of the Deutsche Börse Commodities supervisory board, and co-chairs the International Emissions Trading Association’s (IETA) working group for EU ETS – explains the effects businesses can expect.

Ingo Ramming highlights that the main consequences of the emissions trading reforms are expected to be a considerable shortage in the issuance and allocation of free certificates over the coming years, as well as a large reduction in the auction volumes for 2019 and 2020.

The significance of certificate shortage in detail

The shortage of certificates in 2021 is likely to force industrial clients to buy additional emissions rights. According to Ingo Ramming, “They are expected at a higher price closer to 20 euros per tonne (as they are currently being traded), rather than the 5 euros per tonne seen in previous years. Companies will adjust their procurement and hedging strategies as any eventual increased costs and significant price volatility create the need for a more active approach."

How Commerzbank supports companies with risk management and emissions trading

Our close involvement with the development of this sector spans over 15 years. In 2001, we were part of the pilot project which launched the first CO2 certificate auction in Germany. Then, in 2004, Commerzbank concluded the first ever ISDA-documented transaction for EU emissions allowances. More recently, we have been supporting companies’ preparations for phase 4 by locking in current emissions certificate prices, thus allowing them to hedge some of the pricing risk. We can support our corporate clients from start to finish in the emissions trading process. This includes assisting in calculating the possible surpluses or deficits in emissions allowances and then presenting potential action strategies. Active management of the resulting commodity price risk is increasingly important to our customers. Working together with our new customers, we help them to achieve a holistic understanding of their risk profiles and vulnerability to ETS reform. Our involvement in the evolution of emissions certificates trading and our proven experience in risk management therefore make us a valuable market participant for any business impacted by phase 4.

Proactive risk management increases planning certainty

Together with the corporate client, Commerzbank will help to develop a bespoke risk management strategy. Frequently-used strategy concepts include:

Passive strategies: CO2 certificates are acquired shortly before the compliance reporting date. Sales are made at either the end of the year or quarter.

Tactical/active trading approach: Company uses market opportunities to buy or sell emissions allowances as soon as a predefined price threshold is met.

Hedging/purchasing strategies: The company regularly defines a strategy for how certificates will be acquired or disposed of.

Since businesses requiring CO2 certificates face unique challenges and therefore bear unique risk profiles, it makes sense that they use a specialist toolkit to address them. Commerzbank has a broad range of instruments to help companies manage commodity price risks, with a specialised range available specifically for emissions trading. Unlike interest rate and exchange rate risks, commodity price risks can have a direct negative impact on a business. Our proposition can allow a company to adopt specific sales tactics to extract the most value from their certificate allowances and the denominations of sales include:

Spot purchase or sales:

A company acquires or disposes of EU emissions rights with immediate delivery and pays or receives the corresponding price. This instrument can be used for annual settlement in April, or generate profit through sales.

Forward purchase or sale:

The company sets a price today at which their CO2 certificates will be bought or sold in the future, allowing the customer to hedge against rising or falling prices.

Limit order:

Commerzbank buys or sells emissions rights at a target spot or forward price on behalf of the customer. This strategy can enable companies to be highly flexible.

Purchase at average price:

Emissions rights are acquired or sold at a previously defined average price. In this way, companies avoid having to settle transactions priced at historically high or low levels.

Option:

Using options, or the right to be able to buy and sell CO2 certificates, customer’s hedge against extreme price developments. These can also serve as the basis for generating premiums.

Swap:

In order to manage their compliance positions, companies can exchange a set quantity of certified emissions reductions (CERs) for EU emissions rights (EUA).

Financing:

By simultaneously selling EU emissions allowances on the spot market and repurchasing these on the forward market, companies can receive funds and finance themselves.

The ETS market is in a state of flux. As a pioneer and market leader, we can provide solutions to help our clients meet the challenges ahead.

This publication is treated as customer information within the meaning of the Securities Trading Act.

This information provides information only and does not constitute individual investment advice, nor does it represent an other to buy or sell any securities or other financial instruments. This document alone does not replace individual investor and/or investment-oriented advice.